Protecting the Seed Investor - Band of Angels-10-16-13
1. Band of Angels:
Protecting the Seed Investor
Convertible Notes, Capped Notes, Series Seed and
Preferred Stock Investment Structures
October 16, 2013
James C. Chapman,
Partner, Bingham McCutchen LLP
2. Convertible Promissory Notes
• Rationale for Convertible Promissory
Notes
1. They are a quick and easy structure
2. Low transaction costs
3. Avoid the challenging issue of valuation
4. Allow for a conversion discount or warrants
5. Rely on the Series A investor to negotiate
price and terms
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3. Issues
1. Amount of the investment
2. Amount of discount or warrants
3. Term of the Note
4. Conversion Triggers
5. Secured vs. unsecured
6. Concept “Majority Holders”
7. Prepayment
8. Change in Control Provision
9. Board seat/Observer rights
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4. “Capped Notes”
• Rationale for “Capped Notes”
1. Protect investors by placing an upper limit on the price
per share at which the note converts into equity
2. Permit the Note Holder to participate in sharp increase
in value
• Issues
1. Amount of Cap
2. Conversion into common or preferred stock - Impact on
liquidation preference and stock option plan pricing
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5. “Capped Notes” continued
• Sample Provision
• “This Note shall convert (i) into shares of Series A
preferred at a price per share equal to the price
paid by the purchasers of Series A Preferred Stock
less a discount of 20%; or (ii) into shares of
common stock at a price per share equal to a pre-
money valuation of $6,000,000”
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6. Series Seed Financing
• Definition - A Series Seed Round is the sale of
shares of preferred stock under simplified terms
and structure, i.e. “Series A Lite”.
• Rationale
1. A Series Seed round may be as simple and quick
as a convertible note financing
2. There are no “hidden gottchas”
3. This security starts the holding period for long
term capital gain treatment
4. This type of offering has price certainty as
opposed to capped notes
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7. Series Seed Financing continued
• Disadvantages
1. Entrepreneurs seem to have trouble forming
corporations using Legal Zoom much less a more
complicated matter like the documents for the
sale of preferred stock.
2. The documents for the Series A round become
more complicated as a result
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8. Series Seed Financing continued
• When Is a Series Seed Round Appropriate?
1. When the investor cares primarily about
percentage ownership, liquidation preference and
the right to participate in future rounds
2. Valuation is low
3. There is a small investment such as $500,000 or
less
4. Investors are friends and family
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9. Series A Preferred Stock Financing
• Typical Issues
1. Amount of investment
2. Valuation
3. Right Preferences and Privileges
• Dividends - only 5% are cumulative dividends
• Liquidation - 34% are participating preferred (43%
of these are not capped)
• Conversion -voluntary and mandatory
• Anti-dilution -98% of deals use weighted average
• Voting - with the common stockholders or as a
separate class
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10. Series A Preferred Stock Financing
continued
• Protective Provisions - negative covenants
• Registration Rights- Demand, Piggyback, S-3
4. Board Seats/Observer Rights
5. Information Rights
6. Right of First Refusal and Co-Sale Rights
7. Right to Participate in Future Round of Financing
- 8% have pay to play provisions.
• When is a Series A Round Appropriate?
1. $1,000,000 of investment or more.
2. Institutional investor
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11. Differences Between Series Seed
and Series A Preferred
1. No dividend preference
2. No anti-dilution protection
3. No registration rights
4. No comprehensive protective provisions
5. No co-sale rights
6. No voting agreement
7. The representations and warranties are limited
8. No legal opinion
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